Reykjavik in Iceland has suddenly become a lot more affordable to travellers with the country going through one of the worst recessions for decades. Photograph: Gavin Hellier/Getty Images

The sign at Keflavik international airport made for an odd greeting. "Welcome to Halfpriceland," it said. "Are you here for the nature or the exchange rate?" It was quickly deemed offensive and removed. But it spoke volumes about Iceland, and its sudden dereliction.

Not so long ago, Iceland was known mainly as an expensive, exotic geological wonder in the North Atlantic. Now it stands for something altogether different: the first sovereign victim of the financial crisis, and a sobering case study in what happens to a country when an economy falls off a cliff.

The collapse of the banking system and the currency, the krona, has been so severe that it has left a surreal economic landscape: a country gone from rich to poor so quickly that it can no longer afford some imports; moribund construction sites dotted with half-finished buildings; an affable people now reduced to pelting parliament with eggs; newspapers so strapped that they are struggling to afford the paper on which to print the news, just at a time when Iceland has become newsworthy.

Anyone with debt is feeling the pain the most. One of the features of the Icelandic crisis is that most loans - to buy a house, or even a car - were taken out in foreign currencies, to avoid high interest rates and inflation-linked loans in the domestic currency.

Klemens Thrastarson, a 33-year-old journalist, and his girlfriend bought a house with loans in an exotic mix of Swiss francs and Japanese yen as well as krona, as recommended by their bank. When the krona collapsed, their debts more than doubled. The couple and their baby had to move and rent the house out.

"If it reaches the point where the monthly instalments from the housing loan will be equal to my pay cheque, I would have no qualms about handing in the keys to my house, declare bankruptcy and perhaps leave the country," Thrastarson says.

He is not alone. Most young Icelanders are either thinking the same thing or know someone who is. "Three of my best friends have lost their jobs recently. Two of them have gone to Norway and one of them is moving to the Faroe Islands," says Gauti Masson, 19, a former worker at a care home. He says he lost his job "because more educated people were applying". Now, he says, "I might go to Norway too, but I don't really want to leave my family."

The most visible evidence of the crisis is the half-built structures that no one has money to finish. Cranes used to fill the skyline, but now most have been shipped abroad. The most spectacular abandoned project is the shell of a new music hall by the harbour.

Three lonely figures clad in orange stand on top of the building, where hundreds previously worked around the clock. It is not clear who will finish the building, and when. The construction company is bankrupt, and the property is owned by the cash-strapped Landsbanki. Next to the incomplete music house is a huge hole in the ground, where a hotel, a mall and the new headquarters of Landsbanki were supposed to rise. Whether these will ever be completed is anyone's guess. Unnar Josepsson, a construction worker in his late 20s, says: "All construction has been stopped in the Reykjavik area and probably in the country as a whole."

His friend, a carpenter called Jon, says: "I had a foreign currency loan to buy a car, and instead of having to pay 30,000 kronur a month, it's gone up to 45,000. Now, there is no way to get rid of the car. I go home at noon every day because there is nothing to do."

On Reykjavik's main shopping street, there are still plenty of products available, but most of the imports came before the collapse of the krona. Goods imported in the past two months are expensive, if available at all, and that goes for everything from food to condoms. Sales of the latter have been rising sharply in some countries as a curious byproduct of the financial crisis. In Iceland, however, they have fallen 25%, most probably because a packet of Durex costs twice as much as it used to.

Perhaps this is just as well for Iceland's future, as it may take many generations to pay off the country's debts.

However, the collapse of the krona may be good for Icelandic music. The weak krona makes it too expensive to import anything but the most surefire sellable albums, says Kiddi Krisjansson in the Bad Taste Music Store. Guns'n'Roses fans were exasperated when, having waited 15 years for the new album, they had to wait even longer for it to appear in Iceland's stores.

Sales have held up, Krisjansson says, but mostly because tourists with hard currency are eagerly snapping up merchandise which has become so much cheaper for them. Icelanders are settling for listening to Björk and other local acts. "Icelanders are buying more local music. The musicians here are happy. It will be an Icelandic Christmas," he adds.

On three shiny floors of a former fish factory is CCP, a company best known in computer gaming for Eve Online, which has 300,000 participants all over the world - as many inhabitants as Iceland itself. However, restrictions on access to foreign currency for individuals and businesses and on foreign investment into Iceland are making life difficult. "To make new games, we need foreign investors," says Eyjolfur Gudmundsson, formerly an assistant professor at the University of Akureyri, who supervises Eve's virtual economy. "The present currency restrictions are putting us in a straitjacket. We are in talks with the government, but if we can't let capital in, we might be compelled to leave Iceland, even though this would be against our wishes."

At least CCP still generates income. For the auto industry, sales have plummeted 93% compared with the same time last year, according to RUV state broadcasting. Icelanders simply can't afford foreign models. But foreigners can. Haukur Baldvinsson, a car salesman, says that his staff have taken to snooping around the streets for foreign imports, contacting the seller and then flipping the vehicles on to foreigners.

"We are no longer selling expensive Jeeps, but rather smaller Hilux cars that are bought secondhand by Norwegians," he said. "Now, when we see someone driving a Hilux, we get a buzz in the stomach and take down the number. Then we call the owner to ask if he wants to sell."

Icelanders are reeling from the shock of having everything they knew virtually disappear overnight. As well as anger at the government and the central bank, a residual distaste lingers for Britain and the punitive measures introduced to ensure that British savers got their money back from teetering Icelandic banks. For those who have already lost their jobs as well as for those who are still clinging on, the beginning of a new year will bring an increasingly uncertain future.

At this, the darkest time of the year, daylight is just a brief glimmer between night and night. This time, it may take a while before it truly starts getting brighter.

Cold financial wind

Iceland was the canary in the coalmine of the global financial crisis, the first economy to collapse under the extreme pressure of the credit crunch. A housing and consumer bubble blew up during the good times, as the banking sector took on huge overseas debts which at one point amounted to as much as 10 times GDP, around $14bn. As the credit crunch froze markets, banks could no longer refinance these debts; the currency began falling, making the debts even more expensive. Iceland's three major banks collapsed and had to be nationalised. Now inflation is 17%, unemployment looks headed for double digits and Iceland has gone from one of the sunniest OECD economies to one of its most indebted.